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For Real Estate, the Inflation Reduction Act Means More Deductions and More Audits

Since it passed last month, the real estate industry has been overwhelmingly positive about the ambiguously named Inflation Reduction Act, or the IRA. The reincarnation of Biden’s “Build Back Better” initiative under a different name, the Inflation Reduction Act of 2022, includes a number of tax and expenditure provisions affecting a wide range of businesses and people, and there’s a lot to be happy about. 

At its core, energy-efficient developments will be eligible for larger tax credits. The $369 billion that the IRA will spend over the next 10 years may, in the best-case scenario, start a durable feedback loop of more investment and innovation that would benefit property owners for years, if not decades. While there’s potentially a lot of upside for the real estate industry in the 730-page bill, the incentives designed to encourage property owners to address climate change come with strings attached, strings that could be pulled by the IRS.

Indeed, the focus of the IRA seems to revolve around incentivizing clean energy, and you don’t need to look far to find an industry leader who’s running victory laps at the Act’s passing. Patti Mason, Chief of People, Culture, and Impact at Switch Automation, a real estate software company, told me that the federal government is opening up “a lot of different carrots” in the form of incentives and priorities that could sway even the most indifferent building owners. “They kind of direct our interests towards a broad range of tools to help us make better decisions in buildings,” she said. Until now, some landlords in markets that have already been regulating the performance of real estate have decided to pay the penalty rather than do any energy improvements. But with these resources available to them at this point, that might no longer be the case. “I feel like anyone that’s been on the fence is going to kind of come to the right side,” Mason continued. 

By design, the law has more carrots than sticks, or rather, more investment incentives and less punitive policies in order to get developers and landlords to build greener buildings or add energy-efficient retrofits that had been previously considered too expensive. The IRA is receiving mostly praise from the real estate world, especially the vendor side obviously, for addressing climate change by including hefty decarbonization initiatives, but it’s also receiving accolades for what it doesn’t include.

Real estate professionals breathed a sigh of relief when it was announced that the carried interest tax loophole was pulled from the final draft of the bill before it went to Congress. In the broadest sense, the carried interest loophole enables money managers to classify what is essentially their income as capital gains and benefit from all associated preferential tax treatment. Instead of salaries or fees, a percentage of the deal, known as a profit interest or carried interest, serves as the commission for the real estate deal. Due to this loophole, asset managers that receive carried interest compensation are able to pay far less in taxes than they would have otherwise. Instead of the standard federal tax rates of up to 37 percent that are applicable to compensation paid as a wage or salary, managers only pay a preferential tax rate of 20 percent on such gains.

Another change to the tax law created by the IRA is a 15 percent corporate minimum tax as well as a 1 percent tax on certain company stock buybacks. The tax is levied on US firms with adjusted book income of $1 billion or more over the previous three years, as well as overseas corporations with an average US income of $100 million or more. Currently, 470 U.S. businesses sit within that minimum tax range, but thanks to the IRA’s language, many wouldn’t be impacted because they already pay higher taxes than the required minimum.

Due to restrictions included in the Senate-approved version, the revised version will have a smaller impact on companies. The Joint Committee on Taxation projects that the minimum tax will only apply to around 150 enterprises. That minimum tax is expected to have a big impact. From those companies, $222 billion is projected to be raised over the next ten years. However, there is no mention in the Joint Committee’s letter as to who those 150 corporate entities are, nor which industries they belong to.

Despite being a significant source of income for the IRA, the minimum tax has some frustrating intricacies. The minimum will stop certain businesses (when we find out who they are) from paying their corporate returns at a low effective rate. However, officials are currently debating exemptions for this new minimum tax, but this discussion may drag on even after the tax is put into place. Some of the proposals under the IRA’s umbrella will help navigate these new complexities, of which there are many.

The IRA will disrupt more than the built environment, it’s going to shape the future of tax audits. Fortunately, or unfortunately, depending on how up-to-date you are with filing your taxes, one of the most important features of the IRA was to inject money into the Internal Revenue Service (IRS). The IRA gives the IRS, which has been woefully underfunded over the past several years, an additional $80 billion in funds over the next ten years. The money is intended to support tax compliance, enforcement, and desperately-needed technology improvements for the agency. Enforcement, operations support, business system modernization, and taxpayer services are the four primary areas in which the funds will be divvied up. A few additional minor items, such as exploratory research on the viability of a free-file system, are also included.

Just to put things into perspective, the IRS’s budget request for 2021 was only $12.039 billion, a drop in the bucket compared to the IRA’s windfall. The agency will be more than doubling its workforce as well. In addition to the 78,661 full-time equivalents (FTE) positions in conducting its work in 2021 (a decrease of 12.9 percent since 2012), the IRA will usher in 87,000 new hires into the IRS workforce. It seems that the IRA pulled that 87,000 number from a 2021 estimate from the Treasury Department of how many people will be needed to sustain IRS productivity and keep up with retirements and other workforce decreases, so it’s unclear what the exact number of new hires will be. But the idea that an army of new IRS agents is coming to town sparks a burning question: with this new auditing capacity, who will the IRS go after? 

According to the IRS’s commissioner Charles P. Rettig, the answer is exceedingly wealthy individuals and corporations. In a letter to lawmakers, Rettig wrote, “Our investment of these enforcement resources is designed around Treasury’s directive that audit rates will not rise relative to recent years for households making under $400,000.”

With the IRA’s new funding, the IRS aims to address a “tax gap,” or the difference in what people and companies owe versus what they actually pay that is thought to be worth $600 billion. The organization intends to accomplish this by concentrating on high incomes, significant businesses, and intricate alliances. If a household or small business makes less than $400,000 a year, there is likely little impact. But higher earners and larger entities might experience some heightened audit activity in the upcoming years, providing an additional reason to stay up-to-date with changes and keep receipts.

There’s no need to panic just yet. An auditing blitzkrieg is not likely to happen overnight. Forbes estimates that vetting and hiring for 87,000 and conducting the necessary training for those roles will ultimately take years to get up to speed. Even so, with this new funding, IRS audits and other enforcement actions are anticipated to grow dramatically, which roughly translates to an increased capacity for audits by 1.2 million. Who and what will be audited remains a mystery, but the property industry should expect more scrutiny to go along with all of the clean energy incentives that come with the freshly signed Inflation Reduction Act.

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